Reverse Like-Kind Exchange: Process and Rules

A reverse like-kind exchange is a tax-deferral strategy under Section 1031 of the Internal Revenue Code that allows an investor to acquire a new investment property before selling their existing one. This deferral of capital gains taxes provides an advantage in competitive real estate markets, as an investor can secure a desirable property without the risk of losing it while their current property is for sale.

By acquiring the new property first, the investor is not pressured to accept a lower offer on their old property to meet a deadline. The transaction is structured to ensure the investor does not own both properties simultaneously, a requirement for the tax deferral. This method is intended for properties held for business or investment purposes, not for personal use.

The Safe Harbor Structure

The Internal Revenue Service (IRS) established a “safe harbor” framework under Revenue Procedure 2000-37. Following this structure ensures the IRS will not challenge the transaction’s validity. The central figure is the Exchange Accommodation Titleholder (EAT), an independent third party whose function is to temporarily hold, or “park,” the title to one of the properties on behalf of the taxpayer.

This arrangement is formalized through a Qualified Exchange Accommodation Agreement (QEAA) between the taxpayer and the EAT. The EAT acts as a facilitator that holds qualified indicia of ownership to comply with IRS regulations. This prevents the taxpayer from holding title to both properties simultaneously, which would invalidate the tax-deferred status.

Within the safe harbor, there are two primary ways to structure the transaction. The most common is the “Exchange Last” approach, where the EAT acquires and holds the title to the new replacement property, often using funds loaned by the taxpayer. Once the taxpayer sells their old property, known as the relinquished property, the proceeds are used to complete the exchange, and the EAT transfers the replacement property’s title to the taxpayer.

A less common variation is the “Exchange First” structure. Here, the EAT acquires and holds the relinquished property from the taxpayer. This allows the taxpayer to purchase the new replacement property directly. The EAT then sells the relinquished property to a third-party buyer, and the proceeds are transferred to the taxpayer to finalize the exchange.

Key Deadlines and Identification Rules

Executing a reverse exchange under the safe harbor requires strict adherence to two timeframes. The entire transaction must be completed within an exchange period that ends on the earlier of two dates: 180 days after the EAT acquires the parked property, or the due date of the taxpayer’s federal income tax return for the year the exchange took place. If an exchange begins late in the tax year, the deadline may be shorter than 180 days unless the taxpayer obtains a filing extension. Failure to complete the exchange within this period will cause the transaction to fail the safe harbor requirements.

Within this 180-day period, a shorter 45-day deadline exists for formally identifying the property to be exchanged. This period begins when the EAT takes title to the parked property. For an “Exchange Last” transaction, the taxpayer must identify the relinquished property; in an “Exchange First” transaction, the replacement property must be identified. This written identification must be signed and delivered to the EAT.

The IRS provides alternative rules for this identification. The “Three-Property Rule” allows the taxpayer to identify up to three potential properties without regard to their fair market value. The “200% Rule” allows a taxpayer to identify any number of properties, as long as their total fair market value does not exceed 200% of the value of the parked property. The “95% Rule” allows for identifying properties exceeding the 200% threshold, but the taxpayer must acquire at least 95% of the total fair market value of all properties identified.

Information and Agreements for the Exchange

The taxpayer must gather detailed information for the exchange, including legal descriptions and property addresses for the properties involved. The taxpayer’s tax ID number and legal name must also be available for the legal agreements.

The Qualified Exchange Accommodation Agreement (QEAA) is the central contract for the safe harbor structure. This written agreement between the taxpayer and the EAT must be executed within five business days after the EAT acquires the parked property. The QEAA outlines the terms of the arrangement and substantiates the intent to complete a 1031 exchange.

The QEAA must explicitly state that the EAT is holding the property for the taxpayer’s benefit to facilitate a reverse like-kind exchange. It must specify that the EAT will be treated as the beneficial owner for all federal income tax purposes. The agreement also details the obligations of both parties, including property management during the parking period and the mechanics of the final title transfer. It will also address financial aspects like loans for the acquisition, property expenses, and EAT service fees.

The Reverse Exchange Process Step-by-Step

The first step in a reverse exchange is to engage a company that provides EAT services. The taxpayer and the EAT then enter into the Qualified Exchange Accommodation Agreement, which formally initiates the process.

Using an “Exchange Last” transaction as the model, the EAT takes title to the new replacement property directly from the seller. Funding for this purchase is arranged through a loan from the taxpayer to the EAT or through third-party financing arranged by the taxpayer. This acquisition officially starts the 180-day clock for the exchange and the 45-day identification period.

With the replacement property secured by the EAT, the taxpayer must formally identify the relinquished property. Within 45 days of the EAT’s acquisition, the taxpayer must deliver a signed, written document to the EAT that clearly identifies the property they intend to sell. This identification must comply with one of the established IRS rules.

The taxpayer then markets and sells the identified relinquished property. The sale must be structured so that proceeds are transferred directly to a qualified intermediary. This prevents the taxpayer from having actual or constructive receipt of the funds, which would trigger a tax liability.

To finalize the exchange, the proceeds from the sale of the relinquished property are used to pay back the loan that the EAT used to acquire the replacement property. Once any financing is settled, the EAT transfers the title of the replacement property to the taxpayer. This final transfer must occur before the end of the exchange period to complete the tax-deferred reverse exchange.